These Super-Simple Funds Take The Work Out Of Retirement Investing

Each week, one of our investing experts answers a reader's question in our InvestingAnswers' Q&A column. It's all part of our mission to help consumers build and protect their wealth through education. If you'd like us to answer one of your questions, please email us at editors@investinganswers.com and include "Investing Q&A" in the subject line. (Note: We will not respond to requests for stock picks.)

Many of us invest for one reason: to build a big enough nest egg for retirement. Good old-fashioned stock picking is the preferred route for many investors but can be a bit daunting for the novice investor. This reader's question addresses another type of investment that can provide you with a solid retirement strategy.

Q. "I'm a long way away from it, but I'm starting to think about investing for retirement. I've heard of these mutual funds with a year attached to them and you pick the one that's closest to the year that you expect to retire. How do those work exactly? And are they good?" -- Paul, Manhattan, Kan.

This week's question will be answered by InvestingAnswers investment analyst David Sterman:

A. Paul, you're talking about "target-date" funds, and the short answer is, yes, they are a solid investment vehicle. Before we look at your various options with these funds, let's see how they work.

These funds acquire a set of assets and place them into a fund that is aimed at investors of a specific age. Funds that are aimed at people close to retirement load up on low-risk investments such as bonds and Treasury Bills, along with stocks that sport stable and solid dividend yields.

For investors who don't plan to retire for several decades, there are target-date funds that own a riskier but perhaps higher-returning set of assets. This follows the longstanding investing maxim that the greater the number of years until retirement, the more aggressive an investor should be. These funds steadily adjust their mix of holdings as the years pass, focusing on more conservative investments as the end date of the portfolio draws closer.

Though these funds have been around for two decades, they've recently soared in popularity, thanks to the Pension Protection Act (PPA) of 2006. That act allowed employers to automatically enroll their employees into 401(k) plans, and target-date funds became an acceptable option, especially for novice investors. Before the PPA, less than $200 billion was invested in these funds. That figure has quickly soared to nearly $500 billion.

In response to this popularity, financial services providers are now offering a wider range of investment options. Fidelity, Vanguard and T. Rowe Price have the widest range of offerings, though other fund firms also now sponsor target-date funds. It's probably best to stick with the Big Three, as smaller fund firms are always at risk of shuttering a fund that has too few assets under management.

Fidelity's "Freedom funds," each of which has a date attached to them. For example, the Freedom 2030 fund is suitable for investors in mid-careers, while the Freedom 2055 is ideal for investors who have only recently joined the workforce. These funds carry a 0.89% annual expense ratio, and analysis by financial data firm Morningstar found that "long-term performance has been merely decent."

T. Rowe Price Retirement Target-Date Funds sport a more reasonable 0.7% annual expense ratio, yet have delivered solid returns compared to the peer group. That's partially attributable to a more aggressive investing approach, which has paid off while the markets have rebounded in recent years, though "there's more driving performance than just the strategic asset allocation," Morningstar suggests. The fund-rating firm thinks T. Rowe Price's fund managers have proven to be especially adept stock pickers, which could continue to lead to relative outperformance for these funds.

The Vanguard Target Retirement Target-Date Funds get high marks for a fairly conservative approach. "The high-quality bias of the stock and bond portfolios caused these funds to lag their competitors during 2009's speculative-driven rally, but they held up better than most during 2008's financial crisis," according to Morningstar's analysts. Perhaps the strongest endorsement for these funds: a very low 0.18% annual expense ratio. Over the course of many years, the smaller bite from expenses means more money stays in your fund -- and not in the firm's coffers.

Keep in mind that investors in target-date funds shouldn't equate low risk with no risk. Indeed, in the market meltdown of 2008 and early 2009, even the most conservative target-date funds slumped in value. The good news: Those losses were eventually recovered, and these funds have risen in tandem with the broader stockmarket in recent years. Still, expect further bumps in the road as you wend your way toward retirement. As a good rule of thumb, keep several years' worth of living expenses in short-term bonds and CDs on hand, so you can tap those more liquid funds if needed amidst another stock market rout.

The right fund for you depends on your risk tolerance. Even among target-date funds with similar expiration dates you'll find a vastly different mix of assets. That's why you should compare and contrast the holdings of funds offered by the leading 401(k) providers such as Fidelity, Vanguard, T. Rowe Price and others.

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